Amidst the policy maelstrom
We wanted to change tack. A market increase of 5% for the month is good news, and it would be terrific to present a catalogue of underlying fundamentals which are improving to justify such a move. We’ve been looking – for it profits us nought to live a life of undue professional anxiety – but, alas, only to come up short, if not entirely empty handed.
Several months ago, we detailed the six principal lines of thought that govern our outlook and portfolio positioning, and we will further elaborate upon three of them in this commentary. Further, as we highlighted two months ago, within that economic and business backdrop, the other major theme for investors to remember is “It’s the valuations, stupid”. And thus it was in July, with major mining stocks and their mining services second cousins moving in sympatico with increasing commodity prices, notably iron ore, energy and gold. Along with energy stocks, the major miners remain among the most undervalued stocks we see in the ASX200. Across the industrial suite, however, in the context of a stable environment for bonds but a dramatic fall in the currency with the AUD/USD approaching 90, downgrades from Ausenco, Boart Longyear, Sigma Pharmaceuticals, McMillan Shakespeare, and Treasury Wine Estates, well outnumbered upgrades from the likes of Flight Centre, IAG, Hills Industries and (thanks to significant performance fees) Henderson Group.
With respect to the first of our principal lines of thought - lower (global growth) for longer, driven by overcapacity and demographics - the IMF has exposed the Chinese economy to the demographic lens, and concluded that the working age population has already begun to shrink. This is a decade sooner than had been expected, and puts China in the same position as Japan was in 2000. If a virtue of demographics is that it is predictable, the vice is that it can’t be readily changed! As our major market, the import of Chinese demographics for Australia in terms of export volumes and the terms of trade are clear, and highlights again why a sustainable path is rarely one of ever increasing volume (let alone price) in any course of commerce. This demographic position provides some public policy rationale as to why the Chinese have sponsored the compression of a generation of infrastructure development into the past decade. However, it also highlights why extrapolating this cause and effect is folly, especially as Fitch are starting to highlight that the US$14tn in credit added to the Chinese economy through the past four years is equivalent to the stock of the US commercial banking system. Global growth continues to surprise to the downside, and we suspect this trend reflects this level of excess capacity, will continue for many years to come, and is why we fear deflation more than inflation.
Our second principle, the need for deleveraging, has reached the sovereign in Terra Australis. An increasingly cyclical economy, as Manufacturing has given way to Resources and Financial Services, has found itself increasingly geared through the past several years, and whilst it is true the stock of debt is still relatively manageable, it is also clear that returning to fiscal surplus requires more than a “core promise”. Like all budgets – household, corporate or sovereign – to improve a poor starting point requires either increasing revenues (raising taxes), or decreasing expenditure. An excellent report by the Grattan Institute, “The Mining Boom: Impacts and Prospects”, released during the month, highlighted that commonwealth expenditure to GDP had been relatively stable during the past decade, whilst revenue to GDP had been far more volatile. In turn, whichever party wins power in the forthcoming election, the more likely scenario in rectifying a (large) commonwealth deficit is that taxes will rise commensurately.
Finding the winners and losers amidst this policy maelstrom will be important in terms of equity market performance, as was highlighted three times during the past month. As FBT breaks on vehicle leases wound back, shareholders in McMillan Shakespeare lamented the lack of consultation; as did the banks with the proposed introduction of a tax on deposits; as did Echo Entertainment when the NSW Government invited Crown Limited to move to Stage 3 of the Unsolicited Proposal process for a Sydney casino. All of these decisions were inspired by strained fiscal positions, and had significant equity market consequences. After the Resource Super Profit Tax process, which culminated in a Prime Minister being unseated, it is perhaps unsurprising that potential losers from tax changes may not be forewarned. When thinking through “Who are the losers from rising taxes? Which industries or socio demographic groups will be hit ?”, we recall the apocryphal words of the famous US bank robber Willie Sutton, when asked by the judge when being convicted, “Willie, why do you rob banks?”. To which, Willie responded, “That’s where the money is”. In an Australian context financial services, especially banks, are an obvious target for taxation regime change, and will remain so. Healthcare is likely to be another sector under pressure from regulatory change.
The Australian economic cycle has clearly turned, albeit still nascent. Business confidence reached a four year low through the month, and unemployment a four year high, albeit at still very low absolute levels. Relatively high interest rates have tended to keep the currency at high levels for several years, but both are now unwinding, following, as ever, the terms of trade. By way of contrast, most other developed world economies remain below trend, with even the US still harbouring 7.5% unemployment and a faltering mortgage market. Seeing JP Morgan warning they expect mortgage applications through the second half of this year to drop 30% to 40% from the levels of the first half, as higher bond rates (and hence mortgage rates) in the US compress buyer appetite in the US housing market. By way of contrast, the four years to 2007 that saw increasing US mortgage rates also experienced increasing levels of mortgage applications. The US economy is improving but still fragile, and the European economy continues to falter, but the local economy is clearly slowing materially. Hence our third principal - business plans extrapolating prior cycles are folly.
Finally, whilst resources and mining services stocks enjoyed a rebound during July, the chemical twins and explosive manufacturers, Orica and Incitec Pivot, announced profit warnings and underperformed. In both cases, shareholders are paying the price for management adding capacity through boom times; and now attempting to rectify balance sheets as cashflows start to abate. These stocks are reminiscent of BHP and RIO from 18 months ago; an operational and capital productivity focus, finally, sets in once revenues have started to decline. In the short term, clear and present value can be overwhelmed by operational and financial leverage; however, as also reinforced by the BHP and RIO cases through the past eighteen months, often the best investment returns can be garnered through investing at the most uncomfortable time.
Outlook & strategy
We continue to believe the levels of western world monetary policy distortions and Chinese industrial production over capacity will continue to influence Australian equity market returns, and indices are far more likely to continue to resemble zig zags than shooting stars. We continue to believe the domestic economy is facing a period of tumult, with unemployment as likely to surprise to the upside as growth is to the downside, for years to come. A once in a century investment and terms of trade boom, now officially ended, is highly unlikely to be followed by an economic pause that refreshes. Taxes will continue to increase as the Federal Government seeks to curtail the current fiscal deficit. In this environment, a focus on productivity (more commonly associated with foreign earners), and an ability to make the price for the goods and/or services the investee company sells will remain critical valuation drivers. Gearing, especially for stocks exposed to a slowing domestic demand environment, may ultimately hurt equity holders disproportionately.
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